After the November 2009 meeting of the Monetary Policy Committee, the Bank of England announced that it would keep Bank Rate on hold at 0.5%, at which rate it has been since March. It also said that it would spend a further £25 billion over the next three months on asset purchases, primarily government bonds, thereby pumping additional money into the economy: the process known as “quantitative easing“. This would bring total asset purchases under the scheme to £200bn.
But although this represents a further increase in money supply, the rate of increase is slowing down. In the previous three months, £50 billion of assets had been purchased. So does this imply that the Bank of England sees a recovery around the corner? Will money supply have been expanded enough to finance the desired increase in spending – on both consumption and investment?
A problem so far is that most of the extra money has not been spent on goods and services. Banks have been building up their reserves, with much of the money simply being re-deposited in the Bank of England as reserve balances (see Table A1.1.1 in “Bankstats). At the same time, households have been taking on very little extra debt – indeed, In July, total household debt actually fell (see “Payback time) and consumer debt (i.e. excluding mortgages) has continued to fall. If quantitative easing is to work, the money must be spent!
But with the monetary base having expanded so much, is there a danger that, once the recovery gathers pace, spending growth will return with a vengeance? Will inflation rapidly become a problem again with an overheating economy? The following articles examine the issues.
Interest rates held at 0.5 per cent (includes video) Channel 4 News (5/11/09)
Bank of England extends quantitative easing to £200bn Guardian, Larry Elliott (5/11/09)
What the economists say: Quantitative easing £25bn boost Guardian (5/11/09)
Bank of England faced with its biggest split on policy in a decade Independent, Sean O’Grady (4/11/09)
Bank of England expands money-printing programme to £200bn to fight downturn (includes video) Telegraph (5/11/09)
The one thing worse than quantitative easing would be no QE at all Telegraph, Edmund Conway (5/11/09)
BoE: It ain’t over till it’s over Telegraph, Edmund Conway blog (5/11/09)
Bank raises stimulus to £200bn to end recession Times Online, Grainne Gilmore (5/11/09)
Bank of England to inject another £25bn of stimulus money Management Today (5/11/09)
Extra £25bn to stimulate economy BBC News (5/11/09)
Quantitative easing ‘not working’ (video of DeAnne Julius: former MPC member) BBC News (5/11/09)
Boxed in BBC Stephanomics (5/11/09)
The BoE’s £25bn gambit Financial Times, Chris Giles blog (5/11/09)
US to reduce Quantitative Easing as rates kept low Telegraph, James Quinn (4/11/09)
Quantitative easing ‘unpleasant’ BBC Today Programme, Stephen Bell and Wilem Buiter (7/11/09)
Experts debate whether quantitative easing is working (video) BBC Newsnight (6/11/09)
Questions
- What has been happening to the velocity of circulation of (narrow) money in the past few months? Explain the significance of this.
- What is likely to happen to the velocity of circulation in the coming months if (a) the economy recovers quite strongly; (b) recovery is modest?
- What is the relationship between quantitative easing and the growth in broad money (i.e. M4 in the UK)? How will banks’ desire to build up their reserves affect this relationship?
- Is the UK economy in a liquidity trap? Explain.
- Why is it likely that the Bank of England may well engage in more quantitative easing next March and beyond? How is the fiscal situation likely to affect Bank of England decisions?
- Examine the argument for the Bank of England buying more private-sector debt (virtually all of the asset purchases have been of public-sector debt)?
In a speech to Scottish business organisations, Mervyn King, the Governor of the Bank of England, argued that it might be necessary to split banks up. The aim would be to separate the core retail banking business, of receving deposits and lending to individuals and businesses, from the more risky and exotic wholesale acitivites of banks, such as securitisation, speculation and hedging – so-called ‘casino banking’.
Governments around the world, as represented at the G20 meeting at Pittsburg in September, have favoured tougher regulation of banks. But Mervyn King believes that this is not enough. It may not prevent the reckless behaviour that resulted in the credit crunch and bank bailouts by the government. “Never has so much money been owed by so few to so many. And, one might add, so far with little real reform.” And if regulation were to fail and banks were to get into difficulties, what would happen? There would have to be another bailout. As Mervyn King said, “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”
There are two key problems.
The first is Goodhart’s Law. If rules are set for bank behaviour, banks may adhere to the letter of the rules, but find ways around them to continue behaving in risky ways. The rules may cease to be a good measure of prudent behaviour.
The second is moral hazard. If banks know that they will be bailed out if they get into difficulties because they are too big to fail, then this encourages them to take the risks. As Mervyn King said in his speech, “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ problem is too important to ignore.”
So should the banks be split? Is there any likelihood that they will? Or are Mervyn King’s proposals merely another headache for the government? The following articles looks at the issues. The first link below is to his speech.
Speech by Mervyn King, Governor to Scottish business organisations, Edinburgh (20/10/09)
Mervyn King: bail-outs created ‘biggest moral hazard in history’ (including video of part of speech) Telegraph (20/10/09)
Governor warns bank split needed BBC News (20/10/09)
A sombre warning BBC News, Stephanomics (20/10/09)
Alistair Darling rebuffs Mervyn King’s attack over timidity of banking reforms Guardian (21/10/09)
King and Brown in rift over whether to split the banks Independent (22/10/09)
Tucker set to join calls for stricter controls on banks Scotsman (22/10/09)
Testing times for bank regulators Financial Times (21/10/09)
Mervyn King is right – the economy is changing and we’re blindfolded, without a map Telegraph, Edmund Conway (22/10/09)
Questions
- Explain what is meant by ‘moral hazard’ in the context of bank bailouts. Are the any ways in which banks could be prevented from failing during a crisis without creating a moral hazard?
- Does regulation necessarily involve Goodhart’s Law? To what extent is it possible to devise regulation and avoid Goodnart’s Law?
- What are the arguments for and against splitting banks’ core business from more risky ‘casino banking’?
- Does the separation of retail and investment banking necessarily involve splitting banks into separate organisations? If they are not split, how can the government or central bank underwrite retail banking without underwriting riskier investment banking?
The housing market has been very volatile over the past year or so. House prices crashed, but then appeared to stabilise. Since then, however, different sources have given very different opinions and predictions about future movements. According to Nationwide Building Society, house prices have increased by an average of £53 a day during September, but others suggest that they remain stable and that they may fall again in 2010.
Not only are house prices important to those buying and selling, but the state of the housing market is also crucial for the recovery of the economy. For example, the construction industry has suffered over the past year and, as of the 2nd October 2009, unemployment in this sector stood at 17.1%. As more and more workers lose their jobs, their disposable income falls and hence demand in the economy is affected. With the possibility of an election debate between the party leaders, many will be waiting to see what their strategies are to revitalise a struggling economy.
House prices rise an average of £53 a day’ Daily Record, Clinton Manning (3/10/09)
Mortgage approvals dip in August BBC News (29/9/09)
Construction contracts at slowest pace for seven months Construction News, Nick Whitten (5/5/09)
House sales ‘stalled’ in August BBC News (22/9/09)
Housing market needs ‘feel-good’ factor to recover City Wire, Nicholas Paler (26/6/09)
Double whammy for first-timers as prices stabilise and loans dry up Scotsman, Jeff Salway (3/10/09)
Head-to-head view on house prices BBC News, Kevin Peachey (27/8/09)
UK construction industry still contracting, says Cips Guardian, Kathryn Hopkins (2/10/09)
House prices see ‘slight decline’ BBC News (28/9/09)
House prices ‘back to 2008 level’ BBC News (2/10/09)
Construction unemployment rises to 17.1% HomeTown Sources (2/10/09)
House prices up – but so are insolvencies Management Today (2/10/09)
Financial shadow cast by city apartments BBC News (8/10/09)
For house price data see:
Nationwide House Prices
Halifax House Price Index from the Lloyds Banking Group
Housing Market and House Prices from the Department of Communites and Local Government
Questions
- Why are recent movements in the housing market going to be a problem for first-time buyers?
- The ‘Stamp duty holiday’ will soon come to an end. What do you think will be the impact on the demand for and supply of houses and hence equilibrium prices over the next 6 months?
- One of the reasons why house prices have stabilised is a lack of supply. How does this affect equilibrium prices?
- Why is the economy so affected by changes in house prices? Think about what happens when construction workers lose their jobs and how this affects aggregate demand. Then consider how the macroeconomy will be affected.
- When demand for houses increases, why do prices increase so rapidly? Consider elasticity.
Adair Turner, chairman of the Financial Services Authority, the UK’s financial sector regulator, has proposed the possible use of Tobin taxes to curb destabilising financial transactions. The late James Tobin, winner of the 1981 Nobel prize in Economics, argued that a very small tax (between 0.1 and 1 per cent) should be imposed on foreign exchange transactions to dampen destabilising foreign currency speculation and thereby reduce exchange rate fluctuations. Lord Turner’s proposal would apply to a whole range of financial transactions, putting some friction in these very volatile and often highly leveraged markets. Such a tax would discourage some of the riskier and more exotic transactions on which many of the bonuses of bankers have been based.
Not surprisingly, his proposals have been met with derision by many in the banking sector. Many politicians too have been critical, arguing that the taxes will divert financial business away from London to other financial centres around the world. And yet, at the G20 summit in Pittsburgh on 24/25 September, both the German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, argued in favour of such taxes. The result was that the IMF was asked to investigate the practicality of using Tobin taxes on financial transactions as a way of reining in more risky behaviour. A week later the IMF, while ruling out a simple Tobin tax, came out in favour of taxes on the global financial sector designed to reduce speculation.
So who is right? The following articles look at the issues.
FSA chairman Lord Turner says City too big Times Online (27/8/09)
Financial Services Authority chairman backs tax on ‘socially useless’ banks Guardian (27/8/09)
Cutting finance back down to size Financial Times (27/8/09)
Support for tax to curb bonuses BBC News (27/8/09)
FSA boss gets tough on bonuses (video 1) (Video 2) (Video 3) BBC News (27/8/09)
City tells FSA to stick to day job Reuters (27/8/09)
Charities applaud FSA’s support for new bank tax Guardian (27/8/09)
The time is ripe for a Tobin tax Guardian (27/8/09)
Ça fait malus: France gets tough on bankers’ pay The Economist (27/8/09)
Sarkozy chides bankers for bonuses, calls for tougher regulation (video) France 24 (18/8/09)
Politicians Clamp Down on Bankers’ Bonuses BusinessWeek (26/8/09)
Treasury would be crazy not to listen to Turner Guardian (27/8/09)
Three cheers for Turner and tax on easy money Guardian (27/8/09)
What is the City good for, again? Guardian (27/8/09)
Will Transaction Taxes Reduce Leverage? The Atlantic (27/8/09)
FSA backs global tax on transactions Financial Times (27/8/09)
The Tobin tax explained Financial Times (27/8/09)
Could ‘Tobin tax’ reshape financial sector DNA? Financial Times (27/8/09)
Postscript
Turner defends bank tax comments BBC News (30/8/09)
Turner stands firm after Tobin tax backlash Financial Times (1/9/09)
Brown calls for bank bonus reform BBC News (1/9/09)
Brown pledges bonus clampdown Financial Times (1/9/09)
Cut the banks (and bonuses) down to size Financial Times (31/8/09)
Postscript 2
Sarkozy to press for ‘Tobin Tax’ BBC News (19/9/09)
The wrong tool for the job The Economist (17/9/09)
Dani Rodrik: The Tobin tax lives again Business Standard (19/9/09)
Postscript 3
IMF presses for tax on banks’ risky behaviour Guardian (3/10/09)
IMF’s Strauss-Kahn puts bank tax on the agenda Times Online (3/10/09)
Banks and traders threatened by new international tax plan drawn up by IMF Telegraph (3/10/09)
Questions
- Explain how a Tobin tax could be used to reduce destabilising speculation without preventing markets movement to longer-term equilibria.
- How might the use of a Tobin tax on financial transactions help to curb some of the ‘excessive rewards’ made from financial dealing.
- How do Lord Turner’s proposals differ from those of President Sarkozy?
- Examine the advantages and disadvantages of using a Tobin tax on financial transactions. How might the disadvantages be reduced?
- Explain what Lord Turner means by “the financial services industry can grow to be larger than is socially optimal”. How would you define ‘socially optimal’ in this context?
The blame for the global economic crisis has been placed on many different people, but one area that has been severely criticised for the extent of the financial crisis is banking and financial regulation (or a lack thereof). One thing that has been repeated is that we must learn from our mistakes and therefore tighten financial regulation on a global scale. The Institute for Public Policy Research (IPPR) says the ‘rapid return to the City’s bonus culture shows that real reform has been “very limited”’. France in particular is arguing for tighter financial regulation, including curbing bankers’ bonuses to avoid a repeat of last year’s meltdown. However, it is meeting resistance from the UK and USA. Indeed, some banks appear to have extended their bonus culture.
As the banking sector slowly begins to recover, there is concern that few changes have been made to ensure that there is no repeat of the recent crisis. Banks have been warned that they should not resume taking risks, as they did before, as future bailouts by the government (and hence the taxpayer) will not keep happening. The European Union has now unveiled plans for new ‘super-regulators’, but only time will tell whether they will be a success.
EU unveils new ‘super-regulators’ BBC News (23/9/09)
EU proposes new Financial-Market supervision system The Wall Street Journal, Adam Cohen and Charles Forelle (24/9/09)
FSA head launches fresh attack on ‘swollen’ system ShareCast (24/9/09)
Bank crisis lessons ‘not learned’ BBC News (15/9/09)
US, UK resisting French drive for regulation AFP (22/9/09)
European System of Financial Supervisors (ESFS): Frequently Asked Questions Mondovisione (23/9/09)
Tighter grip on economy needed BBC News (13/9/09)
Turner warns against regulation overkill Money Marketing (23/9/09)
EU calls for European Banking, Securities Regulators Bloomberg (24/9/09)
EU financial watchdog to rely on moral authority The Associated Press (23/9/09)
Obama issues warning to bankers (including video) BBC News (14/9/09)
Questions
- What are the advantages and disadvantages of tighter regulation of the financial sector for (a) the UK and (b) the global economy? What forms should such regulation take?
- What are the arguments for and against imposing a statutory capital adequacy ratio on banks that is substantially higher than the ratios with which banks have been operating in recent years?
- In what ways was a lack of financial regulation responsible for the financial crisis?
- Why is the continuation and possibly growth of the bonus culture a potentially dangerous issue for any future crisis?
- The articles talk about ‘lessons being learned’. What lessons are they referring to?
- The financial crisis has affected everyone in some way. What has been the impact on taxpayers?